Once caught in the middle of a national pay-to-play scandal, the $16 billion New Mexico State Investment Council shifted $7 billion to new managers while terminating all of its public markets managers and all but one of its consultants.

And executives at the Santa Fe-based council still aren't done. In the works are:

plans to commit $1.5 billion to real-return asset classes for the first time and an additional $500 million per year in private equity;

a switch to an asset allocation that stresses income-producing assets over more volatile equity or equity-like investments. The new asset mix is designed to perform in good markets and economic meltdowns;

a proprietary risk management system with the help of Mariner Investment Group LLC, one of its three hedge funds-of-funds managers;

a reorganization of the council from one controlled by governor's appointees to a body that includes appointees from the state Legislature and has fixed-term appointments of council members;

a bill to be proposed in the legislative session in January to take control of council personnel including pay and budget; and

a global analyst network of 70 to 120 investment professionals in money management shops across asset classes that is expected to dramatically increase the information flow into the council's investment office.

Already, the overall investment portfolio has been through an ambitious reconstruction that resulted in the council's largest pool of assets, the $11.2 billion Land Grant Permanent Fund, returning 18.1% for the year ended Sept. 30. For the entire portfolio, assets were up 17% for the year. This ranks the council second for returns in the Wilshire Trust Universe Comparison Service among public funds with $1 billion or more in assets.

New Mexico Gov. Susana Martinez, council chairwoman, said in a written statement for Pensions & Investments that she is “encouraged by the ambitious reforms the council has implemented in such a short time.”

“After years of questionable investments and poor investment performance, today's council is focusing on transparency, good governance and what is best for the people of New Mexico,” Ms. Martinez said. “Our strong investment returns suggest that we are now back on the right track.”

Three years ago, the program was a mess. Returns were poor — -7.43% for the year ended Sept. 30, 2009 — and the council was rocked by a pay-to-play scandal. Among those named in a lawsuit filed by the state attorney general was Gary Bland, former state investment officer, who allegedly made alternative investments pushed on him by politically connected individuals, according to the lawsuit, which is ongoing.

“The portfolio needed major surgery and we knew that,” said Steven K. Moise, state investment officer since 2010, after the scandal came to light.

Deviated from policy

In 2009, investments were essentially in the hands of the state investment officer, an appointee of the governor. The council only approved policy and, in practice, investments made by the state investment officer tended to deviate from the investment policy, said Charles Wollmann, council spokesman.

In 2010, the state Legislature altered the makeup of the council to depoliticize it and increase its powers, which included the council's appointment of Mr. Moise as state investment officer.

Over the past two years, the council has launched 23 requests for proposals for money managers and consultants.

“We changed all but one of the consultants (Sun Mountain Capital), the consultant for our small in-state private equity fund. We changed a number of money managers that were underperforming or had other issues,” Mr. Moise said.

At the same time, council officials conducted a nationwide search for a deputy state investment officer, who is essentially the endowment's chief investment officer. They selected Robert “Vince” Smith — former CIO of the $13.5 billion
Kansas Public Employees Retirement System, Topeka — who joined the council in 2010.

There were three big issues when he arrived, said Mr. Smith. The first was the portfolio's 8.5% return target. In order to meet that target, the portfolio had to have a high allocation to equities. The total equity risk exposure was 75%, including a 70% allocation to equities and equity-like risk in other portfolios.

The council lowered its target to 7.5% 18 months ago, Mr. Smith said.

Secondly, 40% of the portfolio was managed in-house by 12 people who did not have the resources to manage that amount, Mr. Smith said. Today, less than 10% of the portfolio is managed in-house.

The third issue was the poor quality of the portfolio construction, he added. “There were arbitrary fee caps and a weak manager selection process that led to some pay-to-play,” Mr. Smith added.

Mr. Moise said there's much more to do. He wants the council to take on more responsibility for investment management, budget and personnel. Legislation that will be considered early next year will allow hiring and firing of staff and allow the council to manage its own budget — and boost pay for investment professionals while also removing tenure.

A new asset allocation adopted last year moves the portfolio into more income-producing investments and avoids volatile ones dependent on capital gains, Mr. Smith said. It added a 10% real-return target, doubled its real estate allocation to 10% and bumped up absolute return three percentage points to 8%.

It reduced its equity exposure to 56% — 31% domestic equities, 15% international equities and 10% private equity — from 75%. Also reduced was intermediate-duration fixed income, by four percentage points to 16%. The private equity allocation remains at 10% and the legacy private equity portfolio, now 10% of assets, is being allowed to wind down while the number of private equity relationships is being reduced.

Real-return commitment

The commitment to real-return assets will be made in the next six to nine months and will include real estate, inflation-protected bonds and real assets. The council is shifting 65% of the real estate portfolio into core. Another $500 million is planned to be committed to four to six private equity funds with commitment sizes of $75 million to $100 million per year.

Also on tap are possible RFPs for real estate investment trusts, master limited partnerships, beta overlay and transition management, according to the council's current RFP schedule.

“The portfolio overall has 80 managers with 118 funds. That's too big a size,” Mr. Smith said. “We want to narrow to 40 to 50 core managers to make it more manageable to oversee.”

The council already cut its hedge funds-of-funds relationships to three managers from about 13; those firms will run a new 8% hedge fund allocation, Mr. Smith said. “We had wide diversification of assets and strategies. It was all over the map with several hundred underlying funds. I'm sure there were duplicates,” Mr. Smith said.

The new hedge funds-of-funds portfolio aims to be diversified with low volatility and a low performance benchmark of LIBOR plus 3%, he said. Mr. Wollmann said Mariner has performed “within expectations” and has outperformed its benchmark, the HFRI Fund of Funds index. It earned 3% for the year and an annualized 0.98% for the five years, both ended Sept. 30, compared to the benchmark's 2.94% for the year and -1.63% for five years.

The new portfolio is intended to withstand another market downturn, he said. Council officials are doing that with quality bias in the equity portfolio and by shifting some interest rate risk to credit risk in its fixed-income portfolio. For example, the council shifted to the
Barclays Capital U.S. Universal Bond index, which has about 70% in sovereign debt and the rest in credit, from the
Barclays Capital U.S. Aggregate Bond index, which had 85% sovereign debt.

This article originally appeared in the November 26, 2012 print issue as, "New Mexico fund marks progress, plots more reform".